ETF Pro Says Stocks Aren't Worth the Risk

ROBERT ARNOTT LOVES COLLECTING motorcycles dating back to the 'Twenties and traveling the world in pursuit of solar eclipses.

But Arnott, the manager of the $12 billion-asset Pimco All Asset Fund, finds nothing sunny about the prospects for stocks in the coming years.

"I think we are more likely than not to have a bear market sometime this year,'' he says.

In a wide-ranging interview with Barron's Online, Arnott, the chairman of Research Affiliates, a Pasadena, Calif.-based subadviser to Pimco, talked about how investors can successfully diversify their portfolios from a classic reliance on stocks and fixed-income instruments lacking inflation protection.

He also talked about why exchange-traded funds based on fundamental measures such as dividends, profits and book value are simply a better mousetrap than the more traditional market-weighted kind.

Indeed, a number of the funds he developed that are now being marketed by PowerShares are easily outperforming their market-cap weighted equivalents. Recently,
Charles Schwab
began offering "fundamental index" mutual funds in partnership with Arnott's firm, so it's clear that the concept has gone mainstream.

Barron's Online:In your role as an asset-allocation fund manager, you've been very bearish on stocks. Why?

Arnott: The earnings of an S&P company is about 50% above the 10-year average historically, and that is never a foundation for good earnings growth. And so unless we buck that historical norm, we're in for some serious earnings surprises in the next couple of years. And valuation levels are high relative to a historical average over the past decade. We are also looking at the cost of capital that is fairly substantial in real terms. The fed-funds rate is now 4% above core inflation -- that's a pretty high real rate. And we also have consequences of what some have characterized as a real-estate bubble, but was really a lending bubble. It is not that real estate so much soared on its own. It is that real estate was fueled by lending excesses, lending to people who had no basis to borrow.

Q:Can you tell me what the stock weighting is as a percentage of total assets of the Pimco All Asset Fund? A: I'm only allowed to talk about year-end allocations. As of then, we had only about 11% or 12% of the portfolio in stocks. And our charter allows us to go up to 50%.

Q:I know that your decision in late 2005 to lower your equity rating resulted in fairly low positive returns for your fund in the past couple of years. You basically weren't that exposed to the bull market. Do you have regrets? A: Yeah. But what is interesting is that the benchmark for the All Asset Fund is not stock and bonds but TIPs, or inflation-protected Treasuries. This fund is intended not as a balanced stock/bond portfolio, but as a diversification away from mainstream stocks and bonds. And as such, if what you are looking for is real returns, TIPS are the natural way to do that. We beat the TIPS market by 3%. We've beaten the TIPS market every single year since we launched the strategy.

Q:What are the best assets for investors to diversify their traditional stock and bond portfolios?

A: I'd pick three asset classes. I'd start with commodities, which are negatively correlated with mainstream stocks and bonds. They aren't necessarily a brilliantly attractive play for high returns, but they are sure going to reduce your volatility.

The second is TIPS. [Editor's Note: Like regular Treasuries, a TIP pays interest every six months and pays the principal when the security matures. The difference is that the coupon payments and underlying principal are automatically increased to compensate for inflation as measured by the consumer price index or CPI.] And the third are international bonds in their home currency. The other big risk that most investors in the U.S. have absolutely no defense against is the tumbling dollar. And so these are three asset classics that most investors have far too little invested in. These three assets comprise roughly half the money in the All Asset Fund.

Q:If you had to give yourself a grade about how good an asset allocator you've been in the past three years, what would it be and why? A: I would say a B-minus. The big miss was being cautious on equities a little too soon. We did leave some chips on the table. Still, we did make some very timely shifts in the commodities arena turning cautious on commodities last spring and becoming much more enthusiastic on commodities by year end. We did make some very timely shifts in the emerging markets. So I feel good about how we've done in delivering respectable real returns at a very modest level of risk.

Q:I suspect that you would give yourself a much better grade these days as a creator of fundamental or enhanced ETFs. Many of these fundamental indexes are outperforming traditional cap-weighted indexes. And Smart Money magazine recently named the
PowerShares FTSE RAFI US 1000 Portfolio
(ticker: PRF) as the best ETF of 2006. Why are fundamental indexes a better mousetrap than a typical market-weighted index ETF like the iShares S&P 500 Index Fund? Why is it worth paying an extra 50 basis points in annual expense?

A: With conventional indexes, you are weighting the index by the total market value of the stock. So with market-capitalization weighting, which is the classic framework for indexes, you are going to put most of your money in overvalued companies. In using fundamentals to create the index instead of market weighting: Let's suppose, a company's dividend is 4% of the dividends of all publicly traded companies and 3% of earnings of all profits of publicly traded companies and 1% by book value, and 2% of sales. We could just average the four numbers and say, you know, this company is about 2&frac12;% of the economy. Let's use that average as the basis for our weighting. By doing that you smooth out the rough edges of a single metric approach.

Any of the measures -- whether you are using sales, profits, book value, or dividends -- deliver drastically better performance than market-cap weighting going back 45 years in the U.S. We've tested it. The idea is remarkably robust across multiple markets. So what we find is that whatever measure you are using, it winds up producing a much superior index because it severs the link between the weight of the portfolio and over or undervaluation.

Q:How often is the index updated?

A: The index as published by FTSE [a British-based provider of stock indexes] and is reconstituted once a year in March, and it doesn't have to be done more often than that because the turnover is only 10% a year.

Q:What's the single biggest mistake that investors routinely make and should avoid at all costs? A: Chasing recent past returns.

Q:What is your long-term view of the stock market looking out five or 10 years? A I would expect 10-year returns on stocks to be 5% or 6% annualized. And you can get [almost] that on Treasuries right now.

Q:So why take the risk? A: So why take the risk.

Correction: An earlier version of this story mischaracterized the type of funds that Charles Schwab began offering in partnership with Robert Arnott's firm. In fact, Charles Schwab is offering "fundamental index" mutual funds.

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